Greedy Goblin

Friday, December 30, 2011

Spreading investments

A serious idiocy pollutes the mind of many people in the real world banking: spreading your investments for lowering your risks. A little bit of USD, little bit of YPJ, bit of gold, bit of state bonds, bit of CDS, bit of everything! This way you can't lose!

I wish I knew who was the first idiot who made this nonsense up and how could he find followers?!

By spreading your investments, your portfolio will more and more represents the average of the the instruments on the market. And by having an average instrument, by definition you will get average returns. Too bad that average returns on a negative-sum system is negative.

Maybe that's the problem. Many people still don't believe that trading with papers is a negative-sum action, despite it can be easily proven. You can't eat papers. You can't wear them either. They can't cure you when you sick. They are not goods. They are a form of money. Money is not wealth. Money is a measurement system for wealth. It can be printed endlessly with no effect. At the end of the day you need goods and if the amount of goods is fixed, then the average access to goods is fixed. Juggling with money and papers have two and only two effects: one is inflation, the average guy gets more money, yet no more access to goods, so the prices inflated. The second effect is wealth transfer: the average wealth of the players is the same, but one of them got richer at the expense of the others. Since the juggling itself has costs (infrastructure and salary of people running it), the above zero-sum actions turn into negative sum.

You can score big by juggling: you win the wealth of dumber jugglers. But the idea that "everyone" can increase his wealth, by letting "your money work for you" is a simple lie. It's told by those who score big. You are not a partner in this business. You are the mark.

Seriously! What were you thinking? You don't even do juggling, you don't pick instruments, you just sign some papers and get rich? Are you that stupid? Either do the research yourself and take a risk by buying the instrument you think the best or don't juggle at all, spend your money on goods you think will serve you well.

PS: No, I'm still not a "we are the 99%" punk. I'm all for free market and the unrestrained juggling with poisoned papers. Tomorrow I'll tell you why.

Spreading investments is not done to get rich, and if anyone is doing it for that purpose, he is an idiot.

Spreading investments is done to protect your current wealth. As once the money is spread correctly there is lesser chance that everything drops, and you lose your entire wealth.

Trading papers is not a negative sum action, at least not papers of rich countries. As they print more money, they manufacture more, and the value of the papers stays roughly similar. Again, assuming no big economic failure happens. And if it does, well that's why you spread your wealth, hoping that the failure won't reach everywhere you put the money at.

You ignore the value of security. No rational person ever asserted that the best way to get a good return is to diversify like crazy. People just value security over high returns.

Let me paint a simple example. You have $1 million to retire on. There are only two investments available. One is guaranteed to give you a 1% return. The other has a 90% chance of giving you a 90% return and 10% chance of losing 90%.

Clearly, the risky investment is the best, but say you did some calculations and decided that you could retire on half a million and are willing to roll the dice with half of your portfolio. But you cannot retire on $100K. That would be a disaster, as you no longer have a lifetime in which to rebuild your lost savings, and you would have to live the rest of your life out in near poverty.

Betting half on the risky investment and half on the safe one is perfectly rational here.

The point of "having your money work for you" by investing in a portfolio for an average return is really just to compensate for inflation.

Money, as you say, is not a real good. Investing in money (e.g. in a sock under the mattress) will almost certainly give a negative return for the reason you outlined, so you invest directly or indirectly in real goods or property that will hold their value. If you're smart, or lucky, your goods and/or property will increase more in value relative to other things and you'll come out ahead.

Interestingly, you yourself (according to a previous post) have invested in money - US banknotes in a safe deposit box. Normally this would be a pretty bad strategy, since inflation is almost certain to leave you with a negative return. However, what I think you've done is not invest, but hedge - against the collapse of the Hungarian Forint. Maybe not a bad idea, though USD is probably not what I'd choose in a similar situation.

Gold, of course, goes up and down just like any other commodity and is no more safe than any other commodity.

On the original post, you seem to mixing a whole bunch of different concepts together and the whole post is mostly incoherent as a result. There is a big difference between long term investment and day trading or "paper juggling". Long term the Dow Jones has returned 8.8% per year since 1929. So arguing that investment has no returns is either being willfully ignorant or making the claim that something fundamental has changed which will prevent that from being true in the future. That might well be the case but you have made no coherent argument supporting this today or ever.

Also, you seem to misunderstand the balance all investors try to strike between maximizing returns and minimizing risks. It is not an either/or game.

Diversification is the risk mitigation portion of the equation. It is hedging your bets. It will absolutely not ever give the best return. It will increase the likelihood of getting a return greater than or equal to your target. 'Eaten by a Grue' explained that well, but you do not seem to grasp it.

I agree with your assessment that multicurrency is not the best way for most people.

However, for people with large asset pools (AKA no day job) who are already "making their money work for them", an 'average' return is enough. Most people with large (but not ultra rich) incomes are happy to take a very low risk "average" return on their money.

Also, for the average person, diversifying your assets and spreading your investments into different types of investments, such as precious metals, real estate, currency, and stocks is a very good way to manage your portfolio.

Diversity means a crash in any of those markets will not wipe you out entirely.

@GevlonThere is no way of storing wealth that "cannot go wrong".Gold? Here's a price history of gold. If one invested all his money in gold in 1981, then retired in the 90s, he was out of luck (that chart is not adjusted for inflation). Stupid to invest money in gold when its price is hiking? Well it kinda hiked in 2008... and is now hiking twice as high. There is no telling when its going to drop and how long its going to stay down.

USA is printing money like all fuck and they will have to keep doing that unless they somehow get their budget under control (which their voters won't let them). So I don't see how that's very safe either.

Sure, investing in gold or USD is very unlikely to lose ALL the money, but a devaluation by half is quite possible. Something that is far less likely if one's money is spread all over the place.

"You're having a small oversight. Money represents future expected goods too. Everyone can get richer now, if the 'future will be better tomorrow'."

Well, the main ideea in capitalism is that the future MUST be better then the present . All the money existing in the world ,when created, are launched in the market as lending/borrowing by Central Banks/banks. That mean that overall the system need growth at least the size of the overall interest.

If we live on an island and this year our banks lend into existence 100 gold with 5% interest next year overall we need to grow with 5% else for sure someone will default and bankrupt. Capitalism need growth to exist . No growth for lot of years mean the doom of the system and a wave of bankrupcies in the economy .

And now come the big problem : the mathematic say that

YOU CAN'T HAVE FOREVER EXPONENTIAL GROWTH IN A FINITE WORLD WITH FINITE RESOURCES.

USD is devaluateing constantly. Just an example: Say on 01.12.2011 you exchanged your HUF Savings into USD and put them in a Safe.You exchanged HUF 10'000'000.00 into USD and you got USD 44'053.04.

Now today you, for some reason, need that Money and take your USD out of the Safe to change them back into HUF. you would get HUF 999'981'981.48 back.

By the way, had you exchanged your HUF 10'000'000.00 on 01.12.2007 you'd have gotten USD 57'821.85 for them...

Also, spreading you Investments is a way of protecting you current wealth. you will not gain very much, but overall your Investments are safe. the more you focus your funds, the riskyer it get, but also it can generate great revenue (also, you can loose a shitton in a heartbeat)

Your premise that the amount out goods its fixed. It is intuitively obvious that we produce more than in the past: the pharos produced far fewer cars than we do and we produce far more food than even a hundred years ago. A population of seven billion needs seven times the food of a billion.

In fact one of the base problems with modern capitalism its that it its based in unsustainable exponential growth. Or are suggesting for the last 10,000 years world GDP has always been around 60 trillion dollars?

It took until Guthammer's comment, but at least someone finally pointed out that the amount of goods produced is NOT fixed. The economy is not a zero-sum game, a lot of economic growth involves creating a market that didn't exist before (MP3 players) or selling more of something than you were before (families having 2 cars rather than 1 car). In both cases, the total value of goods being produced goes up. If economics was a zero-sum game, then the average standard of living could never go up...but it obviously has in the long term.

The reason why people suggested to spread out your USD investment to decrease risk is pretty obvious. You implied that you no longer trusted the future and wanted a save investment. What if the USD crashes?

Spreading out your investment into a lot of different types of investments would lower the risk. You can have art, gold, raw materials, boxes of cigarettes and different valutas to give an example.

In the worst case scenario you can trade cigarettes/food/water/gold(for buying bigger things), while every valuta has lost its value. In the scenario of just Hungary crashing you will keep everything else, even though USD might be the prefered spending option.

I assumed you wanted to minimize default losses by investing in the USD? Am I incorrect?

This is why rich people are both rich and rare. They take what everyone would call "insane" risks and get very , very lucky by both being in the right palce at the right time and taking the right oportunity. Since you cannot predict in advance where such insane gains can be made your odds of success are very low, far less than 1%. So you either spend your life chasing a dream and end up most likely failing with a small number of people succeeding making you believe that you have a chance at winning too, or you just accept the average, albeit slightly below the poverty line life of being jsut a little sub par.

Why subpar you ask, that is because for each one that does make it big, millions have to make a little less than average in order to make up the balance.

As far as printing money goes, inflation will kill any hope of staying ahead, that is how inflation exists, but constant small actions that devalue the overall worth. For example the population is ever increasing, this means the value of any individual is decreasing in proportion to the whole as there are more and more people capable of replacing you every day.

Stuff like currency trading may be zero-sum, but investment is positive-sum. You have a business plan but no capital. I have capital but no idea what to do with it. If I give you my capital in exchange for a share of your profits, this enables production that would not otherwise have occurred.

Randomly spreading your investments without regard to what you're buying is stupid but no serious investor does this. Handing your savings over to some untrustworthy "investment adviser" is likewise dumb. But there are good wealth managers out there and diversification is a valid risk mitigation strategy when done properly.

Besides, what's the alternative to "letting your money work for you?" Putting cash in a vault where it devalues due to inflation. That's the surest way to get a negative return. But if you invest it well, at least you keep ahead of that loss.

Perhaps the first post you have ever written that i disagree with. This quote is the key one: "By spreading your investments, your portfolio will more and more represents the average of the the instruments on the market.".

that is exactly the point. The point is to minimize RISk. Not to maximize returns (or loss). Slow and steady wins the race, not taking big risk for big rewards.

the fool is usually the one concentrating all his wealth in one stock (vs buying a full market index). Sure, a few get lucky and make millions, but the vast majority lose compared to the index. The reason is that you are assuming 2 risks: the market risk + the individual company risks. Diverify and get rid of that extra risk!

Diversification is an illusion. Today's business practices have allowed companies to leverage themselves across many markets thereby making them very vulnerable to many different market fluctuations. The world economy is nothing but a deck of cards and is only being held together by the mutual illusion that money is actually worth something when in reality it has no value other than the backing of its government and/or its allies. We need to find a way to modify capitilism so it isn't so toxic. Lettting the market regulate itself is going to get us all screwed.

You changed HUF into USD because the HUF was far too risky but you didn't put it into gold because that was far too safe ("If you want security, buy something that can't go wrong, like gold.") so you've gone for the inbetween or average. Yet you appear to be criticising people for investing in average return investments ?

"I bought USD as it can only go wrong in a Mad Max / Waterworld style meltdown"

I have no trouble at all believing that (a) the thought "ok, what if the entire civilized world degenerated into prehistoric barbarism" actually factored into G's investment thinking and also (b) he naturally went to mad max and waterworld when trying to imagine what that would look like. especially waterworld.

this means that it not only is one of the most revealing Gevlon posts ever, but also the most awesome.

Diversifying is a good thing but only up to a certain point. It does offset risk somewhat, but if the whole market goes bad, you will certainly lose money. You want to put no money into investments you think are bad, and spread your money between investments which are good, with more money in the ones you think are especially good. When one of your investments does very well and you think it has become overvalued, you take some or all out of that, and move it somewhere else. But constant juggling is bad, because there are transfer fees, so juggling is best for your stockbroker, not you. Also the older you get, the less risk you want to take(duh). Of course never ever put all your money into one single company's stock even if you think it's a sure thing. Anyways that's my thoughts on good investing, my advice is to not listen to anybody's advice anyway.

From what I read you lack the understanding of what diversify means in the context of thevarious studies that show diversification reduces risk and still achieves the same return. Based on historical returns for different investment classes you can imperically show that you can adjust the asset mix to achieve the same return with less risk. That is why you diversify. It is strictly to reduce to reduce risk and doesn't impact returns. That is the theory. The theory is not as you describe it.

I think what Gevlon is trying to say is that the act of investing is a net negative process. You pay a broker for every transaction, whether buying or selling. They make you think you need to spread your money ouot, invest in great new stocks, etc. so they can take a cut of it every time it gets moved. Look at all the very wealthy families like the Kennedy's and you will not see them moving their money around. It stays put in very secure long term investments.

You ask for who came up with portfolio diversification. While the idea is surely as old as banking itself, one of the most influential exponents of the model is Harry Markowitz, who won the Nobel Prize in Economics in 1990 and was one of the staunch exponents of efficient market theory. His ideas page is here:http://ideas.repec.org/e/pma73.html

Also the stock market represents ownership in companies, not more not less. Clearly technological progress allows much more wealth for society compared to, say two centuries ago. As long as there is technological progress, this can continue. Not everywhere at all times(Congo, Myanmar), but certainly in the US, Western Europe, or Japan. I am not sure why this is should be wrong, the idea is pretty basic really.

I'm surprised. The quality of posts on this blog is usually good, but this has to be the most un-researched and incorrect posts I can remember.

First, let me access the inaccuracies.

"A little bit of USD, little bit of YPJ, bit of gold, bit of state bonds, bit of CDS, bit of everything! This way you can't lose!"

This is totally wrong. The diversified portfolio doesn't mean you can't lose, it means that it lowers your risk. The idea is that if one investment goes down, the other goes up. But this depends heavily on choosing the correct investments in your portfolio. Blindly picking investments won't work.

"Money is a measurement system for wealth. "That's only partially what money is. Money is also a generally accepted currency. So while you're correct in saying that you can't eat money, you can very easily trade it for food. Except for a "Madmax" scenario, money is just as good as food.

"It [money] can be printed endlessly with no effect." This is absolutely wrong. Money, like anything else, is subject to the laws of supply and demand. If you significantly increase supply, you will drop the value of money, and that's what causes inflation. You cannot print money endlessly with no effect.

"if the amount of goods is fixed" It isn't. Technological advances and increased productivity can increase the amount of goods. Some goods are limited (non-renewable goods, such as fossil fuels), but other goods are technically not limited. Food is a good example. Thanks to advances in bio-technology, we can produce far more food than we could by using improved agricultural technology (tractors, watering tech, etc).

"But the idea that "everyone" can increase his wealth, by letting "your money work for you" is a simple lie."No, it isn't. If you can match the average return of the overall market through a diversified portfolio, you will be ahead in the end, because the average return of the market is generally higher than inflation. This isn't always true in the short run, but over the long run, it is.

Don't take my word for it. Go back and look at any 25 year period of the US stock market and economy, and calculate the average market return and the average consumer price inflation. You will find it difficult to find a time where the market return was lower than the CPI.